Candlestick chart patterns: Empower your crypto trading

• Candlestick patterns can be a useful source of signals and bias, and are used by real-life professional traders 

• Some traders combine the patterns with other factors (such as indicators or contextual bias) as a means of trading cryptocurrency markets

• Research into the reliability of candlestick patterns suggests that they do have some predictive value, but as with all trading strategies, their efficacy is likely dependent on various factors

Candlestick patterns refer to the use of one or more candlesticks to generate trade setups from cryptocurrency price charts. 

Developed in Japan during the 18th century, candlesticks remain a widely-used system for visualizing the price movements of financial assets, including cryptocurrencies like Solana (SOL) and Ethereum (ETH).

During certain market conditions, specific candlestick formations can emerge, signaling potential trend changes. 

Understanding how to identify these patterns can offer traders a deeper insight into the directional bias of crypto markets, helping to make more informed decisions.

Candlestick patterns have real utility

In some instances, candlestick patterns can provide traders with valuable insights into potential market directions. When correctly interpreted, these patterns can reveal moments when buyers are becoming exhausted or when sellers are overwhelmed. These insights, combined with effective risk management, form the foundation of a testable trading strategy.

Professional traders use candlestick patterns

Many experienced traders regularly incorporate candlestick patterns into their analysis. And while not every trader will use them, the endorsement from professionals underscores their significance. Understanding these patterns is essential, even if only to recognize how they can influence market behavior.

They can be a great starting point for novice traders

Mastering the complexities of financial markets takes time. Candlestick patterns can offer an accessible entry point for novice traders, helping them grasp fundamental concepts such as supply and demand, support and resistance, and directional bias.

“Price is truth”

Candlestick patterns represent price action in its truest form. Al Brooks, cited as the ‘godfather of price action’ once said that “price is truth,” meaning that price action tells us all we need to know about how a market is trading. High stake professional trader Tom Hougaard also solely focuses on price action.

Candlestick patterns vary in nature. As demonstrated below, they can be made up of one, two or three candlesticks, each boasting their own unique characteristics. 

Single candlestick pattern: The pin bar

The pin bar is a well-known single candlestick pattern signaling that a trend reversal is likely. 

The key characteristics of a bullish reversal pin bar include:

• A long lower wick.

• Little or no upper wick.

• Preferably, the lower wick of the pin bar should sweep below the previous candle’s lower wick, but the body should close above the previous candle.

The opposite can be said for a bearish reversal pin bar candlestick pattern.

If we examine how the bar is formed in a bullish scenario, sellers initially push the price down, but are met with fierce resistance from buyers, who drive the price back up close to the opening level. This results in a bar with a long wick below and a small green body.

In essence, sellers attempted to push the price down but failed. Pin bar candles often signal a trend reversal, especially on higher time frames where the pattern holds greater significance.

Double candlestick pattern: The engulfing candlestick pattern

The engulfing candle is a classic reversal pattern that boasts a number of unique characteristics:

• To engulf means to surround and cover something or someone completely. Hence the name here, “engulfing candle.”

• In the bullish case, the candle sweeps the low but closes above the high of the previous candle.

• Bullish engulfing candles can sometimes mark the bottom of a downtrend, followed by a strong move to the upside.

• They may be more effective as reversals when preceded by four or more candles in line with the trend.

In the simplest terms, an engulfing candle indicates that one side of the market (either bulls or bears) has been completely overwhelmed in a single candle. This pattern can signify the end of a trend, as it demonstrates one side's decisive loss in the battle for market control.

In a bullish scenario, the price may initially drop below the low of the previous candle, attracting sellers. However, as the candle reverses and these new sellers capitulate, the market is driven higher, culminating in a strong close above the previous candle.

Triple candlestick pattern: Rising/Falling three methods

The rising/falling three methods candlestick pattern can sometimes signal a trend continuation.

• The pattern represents a brief pause on the trend, before the prevailing trend continues higher.

• In the bullish example, the rising three methods, three comparatively smaller bearish candles are ‘sandwiched’ by two stronger bullish bars.

• In many ways, it is similar to a bull or bear flag, where the weaker side of the market temporarily halts the prevailing trend, before eventually being overpowered.

The following patterns listed below were created with the following criteria in mind:

• The likelihood of a trader finding these patterns in cryptocurrency markets. Patterns with gaps, for example, occur far less frequently in these markets than other patterns. For this reason, we’ve excluded candlestick patterns with gaps.

• Their performance in Thomas N. Bulkowski’s “Encyclopedia of Candlestick Charts” as well as other research, which empirically tested the efficacy of various patterns.

• Patterns that are known to be used by professional crypto traders.

Bullish candlestick patterns

Three White Soldiers

• A bullish reversal signal made up of three consecutive, pronounced green candles with little or no wicks, demonstrating the shift in power from sellers to buyers. 

Three Stars In The South

• A rare but powerful bullish reversal pattern made up of three bearish candles that slowly fade in strength and size, with the last of the three having a noticeably weaker push to the downside.

Inverted Hammer

• A bullish reversal pattern identified by a bullish candle with a small body and a long upper wick after a pronounced downtrend. The long upper wick suggests that, despite resistance from sellers, buyers made a stand and that the market may reverse shortly thereafter. 

Bullish Harami

• This two candlestick pattern tends to appear after a sharp decline in price, with sellers reaching exhaustion. After the close of a very bearish bar, buyers unexpectedly show up within a small, compact bullish candle, which may precede a reversal.

Bullish Pin Bar

• As the name implies, price creates a pin-like candle — with a small body and pronounced wick — that signifies sellers’ failure to push the price down further, sometimes marking the bottom of a downtrend. 

Bullish Engulfing

• This reversal pattern can signify the exhaustion of a bearish trend and the beginning of a bullish trend, and is identified by a bar that a) moves below the low of the previous candle but b) closes above the high of the previous candle. 

Bearish candlestick patterns

Identical Three Crows

• Made up of three consecutive and pronounced bearish candles, this pattern marks a sharp bearish reversal in the prevailing trend, and can result in significant follow through to the downside.

Three Line Strike

• In the bearish case, when three small bullish candles are immediately met with a violent retracement, this is an indication that a market may be about to move lower. It demonstrates how a new batch of sellers has abruptly overwhelmed buyers' influence over the market. Note, while this pattern is often considered a continuation, it more typically provides a reversal signal.

Bearish Engulfing

• The inverse of a bullish engulfing (described above), a bearish engulfing can mark the end of a bullish trend.

Evening Star

• This three candlestick pattern consists of a small indecision candle, preceded by a strong bullish candle and followed by a strong bearish candle. Similar to a pin bar, this pattern indicates that buyers have run out of steam, and sellers have taken back the momentum.

Bearish Pin Bar

• The inverse of a bullish pin bar (described above), markets often reverse after printing this candle which indicates that buyers are exhausted.

Hanging Man

• This candlestick, with a small body, little or no upper wick and extended lower wick indicates a possible reversal of an uptrend. 

Four continuation candlestick patterns

Rising/ Falling Three Methods

• This continuation pattern is identifiable by three compact, counter-trend candles sandwiched between two much longer with-trend candles. In the bullish case - the Rising Three Methods - sellers establish some brief momentum to the downside before buyers comfortably step back in to resume the trend.

Spinning Top

• This indecision candlestick pattern often forms as part of a pause in an established trend. The candle itself shows how neither bulls or bears were able to convincingly establish their dominance, creating a small compact candle with a thin body and small wick either side.

Three Bar Play

• This pattern is similar to the falling three methods but with a much briefer pause in the trend. In the bearish case displayed above, after a strong bearish bar in line with the trend, buyers have a noticeably weak push up before sellers take back control, sending price lower.

Oftentimes, it’s not enough to simply identify a candlestick pattern and decide to trade it in line with the bias, especially for novice traders just starting out. 

To use candlestick patterns more effectively, traders may decide to backtest their ideas first, then forward test their strategy in live markets. 

For each pattern, traders may find it useful to identify the following points and formulate a clear strategy before entering a position:

1. Entry: a price level or signal that determines the entry.

2. Stop: a price level that invalidates the idea and closes the trade at a loss.

3. Take profit: the price at which a trader exits the trade at a profit.

Please note, these custom trade order types are not guaranteed to execute as desired. 

As an example, let’s imagine that a trader wants to test the potential value of bullish pin bars. 

They might examine every instance where Polygon (MATIC) printed this pattern to see if,

1. There is any edge/signal in trading them.

2. How their efficacy might be improved.

For every pin bar they find, they could apply a particular entry, stop-loss and take-profit strategy and examine how each trade would have theoretically performed. Noting the results, if the strategy shows promise, they may then decide to forward test this approach. Though naturally, past performance does not guarantee future results. 

In conducting their research into pin bars, here are some conclusions a trader might come to:

• Not all pin bars are equal. Some may be much more effective than others depending on the context and/or other factors.

• The strategy may be more successful if the trader waits for prices to retrace before entering.

• Pin bars may work particularly well on certain assets, and not so much with others.

To learn more, check out our Kraken Learn Center article, Crypto trading strategies you need to know

As confluence

The notion of “confluence” in trading simply means combining data from numerous sources. Therefore, some traders use candlestick patterns as part of a constellation of factors that strengthen an overall thesis. 

Some examples of how traders might use use candlestick patterns in combination with other factors are as follows:

• Indicators: Combining candlestick patterns with signals on the MACD or RSI, for example, may potentially generate more successful setups. For example, if you identify a bearish pin bar alongside a bearish MACD/RSI divergence, trading the pin bar could have a greater chance of success given this additional confluence. 

• Fundamentals: Bullish news that occurs at or around the same time as a bullish candlestick pattern, may add weight to a bullish thesis. For example, less than two weeks after Bitcoin’s spot ETF was confirmed, the chart printed a bullish weekly pin bar. In this instance, the combination of bullish technicals and fundamentals led to an improved strike rate. Though this is not always guaranteed to work.

As directional/contextual bias

By looking at what price is doing on the higher time frames, we can generate a bias as to what price is more likely to do on lower time frames. As an example, if a trader sees an inverted hammer on the daily time frame (a bullish reversal pattern), they can then use this information to look for bullish setups on lower time frames. This top-down approach enables traders to potentially find trades with a greater risk-to-reward ratio.

While there isn’t a lot of research examining the predictive ability of candlestick patterns (many academics are skeptical of technical analysis), the overall picture is mixed:

• One study concluded that “...only 5.3% of the time, candlestick patterns accurately predict future price’s movements.”

• A study of candlestick patterns by the Thai stock exchange found that “candlestick patterns cannot reliably predict market directions,” and further that combining patterns with indicators yielded no greater profitability or prediction accuracy. 

• However, certain candlestick patterns were shown to have predictive power in the Taiwan stock market and the Chinese Stock Market

• In his Encyclopedia of Candlestick Charts, Thomas Bulkowski also appeared to show that many patterns were highly successful at signaling reversals and continuations in a variety of scenarios.

It is worth noting that the efficacy of candlestick patterns will likely depend on a few factors:

• The market that they are being applied to.

• The setups generated from them.

• The trader managing the trades in question.

There is an infinite number of ways in which candlestick patterns can be traded, such is the nature of discretionary trading.

In summary, candlestick patterns can provide a useful way to establish directional bias in cryptocurrency markets. They can be used in isolation or with other contextual factors to generate trade setups. 

Research into the utility of candlestick patterns suggests that they may have some predictive value, with some patterns being more valuable than others. However, as with all trading strategies, any signal generated by a market represents just one piece of a much larger puzzle. 

The degree to which candlestick patterns may be effective is likely a function of many factors.

Now that you understand candlestick patterns and can identify some of the most common examples, why not practice your newfound knowledge on the Kraken Pro trading platform?

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